Cryptocurrencies: Building trust

With hundreds of millions of dollars already stolen from digital wallets this year, faith in cryptocurrencies is at an all-time low. Can the industry turn around this bad image, and will the latest surveillance products encourage regulators to take another look?

A string of high-profile digital wallet thefts has shaken investor confidence in cryptocurrencies over the past year, while US concerns over the seemingly unregulated nature of much bitcoin trading remains an obstacle to the listing of crypto-backed exchange traded funds (ETFs). 

The market is, however, far safer and better functioning than its reputation suggests, so long as the right infrastructure, surveillance systems and governance mechanisms are in place. The launch of more credible new exchanges like Beaxy, the publication of compelling Bitwise research into the true shape of the bitcoin market, and the growing use of surveillance and monitoring products like OneMarketData’s OneTick Surveillance and OneTick Best Ex could encourage regulators to take a fresh look at cryptocurrencies, allowing retail trade to scale.

Crisis of confidence
With more than $1.2 billion reported stolen from cryptocurrency exchanges in the first five months of 2019 – up from an estimated $800 million for the whole of 2018 – wallet theft is a public relations disaster for the industry. The year started with an attack on New Zealand-based Cryptopia, which lost nearly 10% of its holdings to hackers and subsequently went into liquidation. In May, thieves made off with 7,000 bitcoin, valued at more than $40 million, from the world’s biggest cryptocurrency exchange, Binance, after hacking into its ‘hot wallet’. While Binance pledged to cover investor losses, the reputational damage had been done. 

Pricing problems – with cryptocurrencies traded on some exchanges at wildly incorrect prices, for reasons ranging from exchange software glitches to fraud – have further dented trust in the industry.

A number of cryptocurrency exchanges have also made the wrong kind of headlines for incorrectly registering initial coin offerings (ICOs), and have been hit with regulator fines or even litigation as a result. For example, the US Securities and Exchange Commission (SEC) launched a lawsuit in June 2019 against messaging app Kik Interactive for listing – but failing to register – its Kin Token as a security under its $100 million ICO in 2017. 

This is just one example of the tougher line that regulators are taking with cryptocurrencies. The SEC has so far blocked every attempt to launch a cryptocurrency-backed ETF. Most recently, it rejected an application, and then an appeal, by the Winklevoss Bitcoin Trust, arguing that bitcoin markets are unregulated and susceptible to manipulation and that cryptocurrencies are therefore not a suitable underlying asset for instruments that would trade on national securities exchanges and be made available to the general public. 

The SEC’s stance partly hinges on its understanding that the vast majority of an estimated $6 billion of cryptocurrency trades executed daily take place outside the US in weakly regulated markets such as China.

Wash trades distort the data?
Recent research by Bitwise Asset Management – which has itself applied to launch an ETF – has however sought to blow a hole in that argument. In a March 2019 presentation to the SEC, Bitwise’s Global Head of Research, Matthew Hougan, argued that the bitcoin market is smaller, more orderly, better regulated and more efficient than perceived. According to his research, 95% of the trading volume the SEC bases its position upon is actually fake or the result of exchanges themselves undertaking back-and-forth non-economic ‘wash trades’ to inflate their own figures.

While Bitwise’s findings do not invalidate all the SEC’s arguments against allowing cryptocurrency-backed ETFs, they suggest that a bigger proportion than thought of global bitcoin trading does in fact take place on better-regulated exchanges in the US, notes Dermot Harriss, Senior Vice-President, Global Head of Regulatory Solutions at OneMarketData. The problem is that putting a firm number on that proportion is currently impossible. With the industry lacking any regulator-sanctioned mechanism for publishing trade volumes, the market’s next challenge will be to help plug that data gap so that regulators can make more informed decisions, Harriss argues.

Exchanges must raise standards
Exchanges can help regulators on that journey by both improving their own surveillance mechanisms and explaining how they work. For example, increased use of surveillance collaboration agreements – an accepted practice in the US under which two regulated entities share surveillance information to effectively monitor each other – would help exchanges gain trust, so long as counterparts are credible.

Freshly launched Beaxy is an example of an exchange moving in the right direction, says Harriss. Based on the OneTick platform, which verifies inbound orders, computes fees and ensures and reserves available funds, Beaxy also uses OneMarketData’s price-matching engine to fill orders and record transactions, as well as its surveillance software.

Ultimately, the onus is on exchanges to raise their standards to levels that regulators will accept. While investments in regulatory oversight, compliance and software may put upward pressure on trading costs for cryptocurrencies – partly eroding an advantage they enjoy over other assets – the resultant trust will bring benefits that more than compensate. Only with the backing of regulators and the trust of investors will trading in cryptocurrencies develop into a vibrant, mainstream retail market. 

John Baskott

Welcome to 1LoD's Global Benchmarking Survey and Annual Report 2019, the largest and most comprehensive survey ever conducted on the front office control sector. This year's report was answered by over 30 of the world’s largest financial institutions. We hope you enjoy reading the findings and thank you to everyone who contributed to making it a success. To find out more about upcoming events, our careers hub or other content from 1LoD just visit www.1lod.com

John Baskott, Co-Founder, 1LoD

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